Expansionary Monetary Policy

How Low Interest Rates Create More Money for You

Two panel image shows a large federal building and a home with a foreclosure sign. Text reads: what is expansionary policy? the first panel reads a central bank uses it to stimulate the economy; lowers interest rates and increase money supply. the second panel reads It’s typically used after a recession has started.

The Balance / Kelly Miller

Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases demand. It boosts economic growth. It lowers the value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary monetary policy.

Expansionary monetary policy deters the contractionary phase of the business cycle. But it is difficult for policymakers to catch this in time. As a result, you typically see expansionary policy used after a recession has started. 

Key Takeaways

  • To counteract an economic downturn, the Fed stimulates demand by increasing the money supply.
  • It does this by changing the fed funds rate, discount rate, reserve requirement, and engaging in open market operations.
  • The Fed’s target inflation rate is 2%.
  • The Federal Reserve created new programs such as TALF, AMLF, and QE to combat the 2008 recession.

How It Works

The U.S. central bank, the Federal Reserve, is a good example of how expansionary monetary policy works. It usually uses three of its many tools to boost the economy. It rarely uses a fourth tool, changing the reserve requirement.

Open Market Operations

The Fed's most commonly used tool is open market operations. That's when it buys Treasury notes from its member banks. Where does it get the funds to do so? The Fed simply creates the credit out of thin air. That's what people mean when they say the Fed is printing money.

By replacing the banks' Treasury notes with credit, the Fed gives them more money to lend. To lend out the excess cash, banks reduce lending rates. That makes loans for autos, school, and homes less expensive. They also reduce credit card interest rates. All of this extra credit boosts consumer spending.

When business loans are more affordable, companies can expand to keep up with consumer demand.

They hire more workers, whose incomes rise, allowing them to shop even more. That's usually enough to stimulate demand and drive economic growth to a healthy 2%-3% rate. 

Fed Funds Rate

The Federal Open Market Committee may also lower the fed funds rate. It's the rate banks charge each other for overnight deposits. The Fed requires banks to keep a certain amount of their deposits in reserve at their local Federal Reserve branch office every night. Those banks that have more than they need will lend the excess to banks that don't have enough, charging the fed funds rate.

When the Fed drops the target rate, it becomes cheaper for banks to maintain their reserves, giving them more money to lend. As a result, banks can lower the interest rates they charge their customers.

Discount Rate

The discount rate is the interest rate the Fed charges banks that borrow from its discount window. Banks rarely use the discount window because there is a stigma attached. The Fed is considered to be a lender of last resort. Banks only use the discount window when they can't get loans from any other banks. Banks hold this viewpoint, even though the discount rate is lower than the fed funds rate. The Fed lowers the discount rate when it decreases the fed funds rate.

Reserve Requirement

The Fed's fourth tool is to lower the reserve requirement. Even though this immediately increases liquidity, it also requires a lot of new policies and procedures for member banks. It's much easier to lower the fed funds rate, and it's just as effective. During the financial crisis, the Fed created many more monetary policy tools.

Expansionary vs. Contractionary Monetary Policy

If the Fed puts too much liquidity into the banking system, it risks triggering inflation. That's when prices rise more than the Fed's 2% inflation target. The Fed sets this target to stimulate healthy demand. When consumers expect prices to increase gradually, they are more likely to buy more now.

The trouble starts when inflation gets higher than 2% to 3%. Consumers start stocking up to avoid higher prices later. That drives demand faster, which triggers businesses to produce more, and hire more workers. The additional income allows people to spend more, stimulating more demand.

Sometimes businesses start raising prices because they know they can't produce enough. Other times, they raise prices because their costs are rising. If inflation spirals out of control, it can create hyperinflation. That's when prices rise 50% or more a month. Hyperinflation is one of the four main types of inflation that are categorized by the speed at which they happen.

To stop inflation, the Fed puts on the brakes by implementing contractionary monetary policy.

The Fed raises interest rates and sells its holdings of Treasuries and other bonds. That reduces the money supply, restricts liquidity and cools economic growth. The Fed's goal is to keep inflation near its 2% target while keeping unemployment low as well.

Tools That Conquered the Great Recession

In 2008, the Fed created an alphabet soup of innovative expansionary monetary policy tools to combat the financial crisis. They were all new ways to pump more credit into the financial system.

The Term Asset-Backed Securities Loan Facility

The Term Auction Facility allowed banks to sell their subprime mortgage-backed securities to the Fed. In conjunction with the U.S. Department of Treasury, the Fed offered the Term Asset-Backed Securities Loan Facility. It did the same thing for financial institutions holding subprime credit card debt.

The Money Market Investor Funding Facility

On September 16, 2008, there was a destructive run on money market funds. On September 22, the Fed established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. This program loaned $122.8 billion to banks to lend to money market funds. On October 21, the Fed created the Money Market Investor Funding Facility to lend directly to the money markets themselves.

The good news is that the Fed reacted quickly and creatively to stave off economic collapse.

The credit markets had frozen up. Without the Fed's decisive response, the day-to-day cash that businesses use to keep running would have gone dry. The bad news is that the public did not understand what the programs did. They became suspicious of the Fed's motives and power. That led to a drive to have the Fed audited, which was partially fulfilled by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Quantitative Easing

The Fed also created a more powerful form of open-market operations known as quantitative easing. With QE, the Fed added mortgage-backed securities to its purchases. In 2011, the Fed created Operation Twist. When its short-term notes came due, it sold them and used the proceeds to buy long-term Treasury notes. That lowered long-term interest rates, making mortgages more affordable. 

Frequently Asked Questions (FAQs)

Why does expansionary monetary policy cause interest rates to drop?

It's a simple function of supply and demand. As the supply of available funds increases due to the Fed's expansionary policies, more lenders have money to lend. As in other markets, the increase in supply drives prices down, so in this case, it naturally pushes interest rates down.

What is the difference between expansionary monetary policy and expansionary fiscal policy?

While the Fed controls monetary policy, fiscal policy involves a different set of tools and is controlled by Congress. Expansionary fiscal policy is also designed to increase monetary supply, but Congress accomplishes this through cutting taxes or increasing government spending. It can take longer to implement changes through Congress, but once enacted, fiscal policies tend to make an impact more quickly than monetary ones.

Article Sources

  1. Board of Governors of the Federal Reserve System. "Open Market Operations."

  2. Board of Governors of the Federal Reserve System. "Is the Federal Reserve Printing Money in Order to Buy Treasury Securities?"

  3. Board of Governors of the Federal Reserve System. "Policy Tools - Open Market Operations."

  4. Board of Governors of the Federal Reserve System. "Policy Tools - The Discount Window and Discount Rate."

  5. Federal Reserves Bank Services. "Reserve Account Administration Application Frequently Asked Questions," Select "Why Did the Federal Reserve Reduce Reserve Requirement Ratios to Zero Percent?"

  6. Board of Governors of the Federal Reserve System. "Why Does the Federal Reserve Aim for 2 Percent Inflation Over Time?"

  7. The Library of Economics and Liberty. "Hyperinflation."

  8. Federal Reserve Bank of St. Louis. "A Closer Look at Open Market Operations."

  9. Board of Governors of the Federal Reserve System. "What Is Inflation and How Does the Federal Reserve Evaluate Changes in the Rate of Inflation?"

  10. Board of Governors of the Federal Reserve System. "Term Auction Facility (TAF)."

  11. Federal Reserve Bank of New York. "Term Asset-Backed Securities Loan Facility."

  12. U.S. National Archives and Records Administration, Federal Register. "Proposed Recommendations Regarding Money Market Mutual Fund Reform."

  13. Board of Governors of the Federal Reserve System. "Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility."

  14. Board of Governors of the Federal Reserve System. "Money Market Investor Funding Facility."

  15. Office of the Inspector General. "Audit of the Board's Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act."

  16. Congressional Research Service. "Federal Reserve: Recent Actions in Response to COVID-1," Page 2.

  17. Federal Reserve Bank of St. Louis. "Let's Do the Twist."